Opinion: The stock market faces a massive headwind in 2018: a lack of new money

Higher interest rates and the end of central bank stimulus will stall the market’s advance this year

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Stock market levels are premised on one thing: supply and demand. And new money determines demand.

By

ThomasH. Kee Jr.

Did the stock market care about higher interest rates in 2017? No.

But, clearly, the market does care this year — at least sometimes — so that begs the question: Is there any material difference between market conditions in 2018 and in 2017? And if there is a difference, why did higher rates suddenly become important?

First things first: The fed funds rate doubled between March and December 2017, so rates did increase last year, but no one cared enough, and the market moved up in a straight line. The S&P 500 Index
SPX, +1.32%
returned 22% last year.

This year the mere talk of higher rates is causing concern, and reasonably the rate increases could be reaching a tipping point. But there’s a much more important culprit to these changing market conditions.

Supply and demand

Stock market levels are premised on one thing, and one thing only. That’s the simple concept of supply and demand. Earnings do not matter, inflation does not matter, politics do not matter and the level of interest rates does not matter. All that matters is supply and demand.

Rightfully, those above-mentioned ancillary variables can affect supply or demand, so they can play a role. But it all boils down to demand — how much money is out there buying stocks — versus supply — how many people are selling.

To measure supply and demand in the stock market, we compare buyers to sellers. If there are more buyers out there, the market will increase regardless of the ancillary variables, and in 2017 there were more buyers than there are in 2018.

Before I continue, there are natural cycles when buyers outpace sellers for periods of time, or when sellers outpace buyers. I defined this as the Investment Rate in 2002, and back-tested the model to 1900. It measured all longer-term cycles in U.S. history in terms of new money, or new demand.

New money

Ultimately, the measure of stock market supply and demand is premised on new money. A buyer who is buying a stock using proceeds from a sale of stock does not positively impact demand because the sale offsets the demand. Another way of saying this is that you cannot churn old money and expect markets to grow. That means new money matters most.

The Investment Rate measures natural changes to new money inflows using a derivative demographic analysis with integrated societal norms, but it is not the only measure of new money.

Central bank stimulus

The Federal Reserve and European Central Bank (ECB) were the second source of new demand for the past five years. The asset purchases they made came from a theoretical printing press. There was nothing natural about those asset-purchase programs, but still they brought a new buyer to the table.

Therefore, there are two things that need to be added together to define new money: the Investment Rate plus central bank stimulus.

Importantly, for the past five years the Investment Rate (IR) has been declining, which has only happened twice before in history. The IR declined between 1928-1938 and 1969-1981. These periods were otherwise known as the Great Depression and stagflation. The rate of change in new money declined every year during those periods. Over the past five years the IR has declined more than in either of those periods, suggesting natural new money demand is declining.

What’s new now

However, central bank asset purchases have been like clockwork for five years, and the impact on new money demand by this non-natural source was significant, until now.

In January the combined asset purchase program of the Fed and ECB was slashed, and it no longer significantly skews the natural demand levels identified by the Investment Rate. The reason this market seems to care about higher rates, and other things it did not care about last year, is that the fake money is almost completely dried up. When new money demand declines significantly, as it has, things that did not matter before start to matter again.

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